The human vs. financial capital trade-off

In life, we're all in the same boat. We each strive to maximise our enjoyment of life within the limited time frames we are allotted. For many, the freedom to pursue some of our enjoyments in life relies upon our ability to effectively convert our human capital into financial capital. What is 'human capital' I hear you ask, as you distract yourself for the next 3 minutes from whatever important thing it is you were doing. Quite simply, human capital is a measure of the present value of your income generating capacity. As a measure it reflects your individual productive capacity enhanced by whatever valuable traits, specific to you, which you possess like industry knowledge, technical skills and entrepreneurial panache. The combination of both financial and human capital provides a measure of your overall economic wealth.

We are almost all far too focussed on measuring the value of our financial assets. So much so that we too often overlook the value that our human capital has in creating financial capital in the future. As human capital is an aggregate measure of future income generating potential, it is at its highest at the start of your career. As we move through our career, how we convert human capital into financial capital will be a reflection on how well we save, invest our savings and grow our careers. The inverse relationship between human and financial capital is demonstrated in the below graph (courtesy of Ibbotson Associates). As your human capital diminishes you should ideally be converting some of this into financial capital.

Once we take stock of the importance of our human capital (especially for those who are younger), we become far more conscious of three things;

How do we enhance the value of our human capital?

By improving your employment or economic value proposition you will significantly enhance your future income generating capacity, translating to a higher amount of financial capital later in life. One of the most effective ways to improve your value proposition is via investment in yourself. At Snowgum, we firmly believe that through personal investment you stand a chance in receiving far more rewarding returns than any alternate investment available. Personal investment might mean pursuing further education, developing a new skill set, establishing your own medical/dental practice, devoting significant time to a companies mission or following your entrepreneurial instincts etc.

How do we protect our human capital?

As human capital is at its highest at the beginning of your career, ignoring appropriate measures to protect this value until "you're older" is extremely risky. The easiest and simplest way to protect your human capital is via personal insurance. Incredibly, we are all comfortable with the idea of protecting the value of our car or the value of our home and yet grossly overlook our most significant and valuable economic asset, our ability to earn income. When did your car become more valuable than you?

How does human capital affect our investment approach?

When considering the impact of human capital on investment strategies, our focus is not on the nominal measure of your human value but the volatility associated with your income generating circumstances. If your employment role is highly cyclical in nature, meaning that your employment prospects ebb and flow with market movements, then we would want to reflect this in our investment strategy.

For instance, as many fly in fly out mining contractors do not have significant long term job security, we would factor in the possibility of a medium term draw down from investment capital (most likely to occur during an economic downturn). On the other hand, a government employed teacher or nurse who's employment is resistant to cyclical factors will warrant an investment strategy which doesn't incorporate unforseen medium term capital draw-downs.

Real life example

Phoebe (you may remember her from previous articles) is a precocious 30 year old who, as a digital community manager for a large bank, has reasonable job security. She delayed her income earning potential by three years when she decided to invest in herself by attaining a tertiary education after high school. Phoebe's enhanced skill set has allowed her to grow her career which sees her now earning an income of $100,000 per annum.

Unfortunately for Phoebe she has recently split from her gym enthusiast boyfriend Zach. This has seen Phoebe fall into a spiral of self wallowing pity. Shortly after this breakup, Phoebe visits her financial adviser for her annual review. She confides with her adviser that since the break-up she feels worthless and is at least grateful that she has a $15,000 car (a pink Mazda 3) and a $10,000 handbag collection to validate her self-worth. During this review, Phoebe's adviser reminds her that she also has an income protection policy in place and a small but growing investment portfolio. This well intended reminder doesn't seem to help improve Phoebe's mood as much as the adviser hoped. The following conversation then unfolds;

After the adviser remarks about Phoebe's financial circumstances, she emotionally quips;

"what's the point of having this policy anymore, I don't need to look after anyone anyway".

Fortunately, Phoebe's adviser is an extremely empathetic gentlemen and is able to set Phoebe's mind at ease.

"Well Phoebe" the adviser says. "The current income protection policy actually protects you against the risk of loosing your ability to earn an income". After receiving no response the adviser boldly continues through Phoebe's sobs; "I know it doesn't make you feel as good as a new Hermes handbag, but what this policy actually says is - you are valuable and your value is worth protecting".

Phoebe's mood quickly changes with this last comment about being valuable and she presses her adviser to outline exactly how valuable the adviser thinks she is... The adviser (knowing he is quickly entering dangerous territory), quashes the thought that this neediness likely contributed to her current relationship status and answers;

"Well, if we consider your current income and the security of your role at the bank, the nominal value of your income from now through to retirement is around $3.5m, making you one very valuable young lady indeed".

Phoebe is extremely chuffed as she mentally calculates how many handbags she can afford in the future. She also noticed that the adviser called her young and this brightens her mood even further.

Although Phoebe hasn't yet had the opportunity to accumulate significant financial capital, she is now fully aware of her economic worth. Through maintaining appropriate insurance, Phoebe has helped manage the risk of an accident or illness drastically reducing the value of her human capital. Additionally, as Phoebe has strong job security and a valuable skill set, her adviser, with consideration to Phoebe's financial objectives, was able to structure an investment strategy to take advantage of her circumstances.